You can choose from several forms of legal structures when establishing a business. The structure you select influences taxes and liabilities, as well as reporting transactions. One way you can organize your business is as an LLC. What is an LLC?
What is an LLC?
A limited liability company (LLC) is a type of business structure that combines the pass-through tax benefits of a partnership with the limited liability of a corporation. Many business owners consider becoming an LLC because of the flexibility the structure offers.
In an LLC, the owners are called members. An LLC can be either a single-member or multi-member business.
An LLC is a separate entity from the owners. The business can register for its own federal identification number from the IRS. Bank accounts, credit card accounts, and business transactions can all be undertaken with the business’s identification rather than the owners’.
Separate entities create limited liability. The owners have financial and legal protection similar to corporations. Forming an LLC is generally more affordable than a corporation.
Some benefits of an LLC are the personal protection and the flexibility of a sole proprietorship or partnership. Unlike corporations, double taxation is not an issue with an LLC. LLCs are only taxed once at the personal level.
LLCs and taxes
Every business structure affects taxes differently. An LLC is a hybrid of tax methods used in other structures. Take a look at how LLCs are taxed and what you are liable for as an owner.
Limited liability companies use pass-through taxation. The business itself does not pay income taxes. Instead, the owners report business income and pay taxes on their personal tax returns. The tax skips the business and falls onto the owners. This creates the need for additional LLC tax forms in both single-member and multi-member situations.
Single-member LLCs are taxed as sole proprietorships. The owner reports the business’s profits and losses by attaching Schedule C to their personal tax return. Schedule C details the business’s profits and losses.
Multi-member LLCs are treated as partnerships in the eyes of the government. Owners report business income and pay taxes on their personal tax returns. Each owner attaches Schedule K-1 to their tax return to show the business’s profits and losses. The LLC sends Form 1065 to the IRS.
An LLC can choose to be taxed as a corporation. By doing so, you do not get the pass-through tax benefits. You are taxed once at the corporate level and once on your personal income. But, you might end up paying a lower tax rate. To elect to be taxed as a corporation, send Form 8832, Entity Classification Election, to the IRS. When you file your business tax return, use Form 1120.
Since an LLC is a separate legal and tax entity from the owners, the owners are protected in the same way as those of a corporation. This is one of the biggest LLC advantages. Limited liability means the LLC members are not personally responsible for business debts.
If the business owes money and cannot pay, only the business assets are at risk. The same goes for lawsuits against the business. As long as the owners have not done something illegal or unethical, the owners’ property can’t be used to cover costs.
Taxes LLC members pay
Owners of an LLC are considered self-employed. Unlike how an employer withholds taxes from an employee’s paycheck, LLC owners do not have taxes automatically withheld from their income. Instead, owners are responsible for estimating, paying, and reporting taxes.
As an LLC member, you need to estimate income taxes and pay them each quarter. Along with estimated taxes, you must pay self-employment tax. Self-employment tax includes Social Security and Medicare taxes, which together are called the Self-Employment Contributions Act (SECA) tax. Self-employment tax is paid quarterly.
Who should form an LLC?
Every business has unique needs for organizing and structuring. Some small business owners will find that their best option is to operate as an LLC.
You might want to form an LLC if you worry about your personal property being affected by business debts. For example, business owners who deal directly with the public should consider an LLC. The more people you work with, including customers, vendors, and employees, the more chances you have of running into overdue debts or lawsuits.
Let’s say a customer slipped and was injured at your store. If the customer sues you, a lawsuit could cost a lot of money. Not being protected by limited liability could mean you have to cover expenses with personal assets. An LLC protects your personal property in these situations.
Although there are many benefits of forming an LLC, some businesses are not allowed to because of government regulations. For example, companies in the insurance industry are usually restricted from becoming LLCs. Review your state laws to see if your industry can be an LLC.
Each state has its own rules for forming and operating an LLC. Check with your state’s department of revenue to find out your requirements.
How to start an LLC
There are several steps you must take to become a limited liability company. The following is an overview of creating an LLC.
First, you need to file articles of organization with your state. Articles of organization list information about your business, including its name, address, and purpose. Most states offer a form for you to fill out.
Usually, you must pay a filing fee to become an LLC. A few states require you to publish an announcement that you are forming an LLC in the local newspaper.
Though it is not required by law, you should create a small business plan. A business plan helps you organize operations and plan ahead. It includes a market analysis, financial projections, and marketing plans. If there is more than one owner, create a document outlining the roles of each member and how much of the business each owns.
If your LLC has multiple members, you might want to create an operating agreement. An operating agreement outlines the rules and regulations of your business. The document helps you and other members stay on the same page when it comes to your LLC.
Digital strategy and communications consultant Ijeoma S. Nwatu explained in an SBA article:
Even if members have orally agreed to certain terms, misunderstanding or miscommunication can take place. It is always best to have the operational conditions and other business arrangements handled in writing so they can be referred to in the event of any conflict.
If you already run an existing business under a different structure, you can convert it into an LLC. Owners of sole proprietorships and partnerships benefit from limited liability without having to change the way the business is taxed.
You can change your company to an LLC in the same way as a new business forms one. You must file articles of organization with your state. Limited liability companies must include “LLC” in the business’s name. To switch to an LLC, you need to change your identification numbers and licenses to the new name.
Need an easy way to keep track of your small business transactions? Patriot’s online accounting for small business uses a cash-in, cash-out system so you can complete your books in a few simple steps. Our software comes with offer free, U.S.-based support. Try the accounting software for free today.
This article has been updated from its orginal publication date (12/4/2014).